Accounting is not an exact science. Professional judgment is required to apply a set of principles, concepts, and objectives to specific sets of circumstances. This means choices must be made. In your study of accounting to date, you've encountered many areas where choices are necessary. For example, management must choose whether to use accelerated or straight-line depreciation. Is FIFO, LIFO, or average cost most appropriate to measure inventories? Would the completed contract or percentage-of-completion method best reflect the performance of our construction operations? Should we adopt a new FASB pronouncement early or wait until it's mandatory? These are but a few of the accounting choices management makes.
You also probably recall that consistency and comparability are two fundamental qualitative characteristics of accounting information. To achieve these attributes of information, accounting choices, once made, should be consistently followed from year to year. This doesn't mean, though, that methods can never be changed. Changing circumstances might make a new method more appropriate. A change in economic conditions, for instance, might prompt a company to change accounting methods. The most extensive voluntary accounting change ever—a switch by hundreds of companies from FIFO to LIFO in the mid-1970s, for example—was a result of heightened inflation. Changes within a specific industry, too, can lead a company to switch methods, often to adapt to new technology or to be consistent with others in the industry. And, of course, a change might be mandated when the FASB issues a new accounting standard. For these reasons, it's not uncommon for a company to switch from one accounting method to another. This is called a change in accounting principle switch by a company from one accounting method to another..
Although consistency and comparability are desirable, changing to a new method sometimes is appropriate.
DECISION MAKERS' PERSPECTIVE—Motivation for Accounting Choices
It would be nice to think that all accounting choices are made by management in the best interest of fair and consistent financial reporting. Unfortunately, other motives influence the choices among accounting methods and whether to change methods. It has been suggested that the effect of choices on management compensation, on existing debt agreements, and on union negotiations each can affect management's selection of accounting methods.2 For instance, research has suggested that managers of companies with bonus plans are more likely to choose accounting methods that maximize their bonuses (often those that increase net income).3 Other research has indicated that the existence and nature of debt agreements and other aspects of a firm's capital structure can influence accounting choices.4 Whether a company is forbidden from paying dividends if retained earnings fall below a certain level, for example, can affect the choice of accounting methods.
A financial analyst must be aware that different accounting methods used by different firms and by the same firm in different years complicate comparisons. Financial ratios, for example, will differ when different accounting methods are used, even when there are no differences in attributes being compared.
Investors and creditors also should be alert to instances in which companies change accounting methods. They must consider not only the effect on comparability but also possible hidden motivations for making the changes. Are managers trying to compensate for a downturn in actual performance with a switch to methods that artificially inflate reported earnings? Is the firm in danger of violating debt covenants or other contractual agreements regarding financial position? Are executive compensation plans tied to reported performance measures? Fortunately, the nature and effect of changes are reported in the financial statements. Although a justification for a change is provided by management, analysts should be wary of accepting the reported justification at face value without considering a possible hidden agenda.
Choices are not always those that tend to increase income. As you learned in Chapter 8, many companies use the LIFO inventory method because it reduces income and therefore reduces the amount of income taxes that must be paid currently. Also, some very large and visible companies might be reluctant to report high income that might render them vulnerable to union demands, government regulations, or higher taxes.5
Another reason managers sometimes choose accounting methods that don't necessarily increase earnings was mentioned earlier. Most managers tend to prefer to report earnings that follow a regular, smooth trend from year to year. The desire to “smooth” earnings means that any attempt to manipulate earnings by choosing accounting methods is not always in the direction of higher income. Instead, the choice might be to avoid irregular earnings, particularly those with wide variations from year to year, a pattern that might be interpreted by analysts as denoting a risky situation.
Obviously, any time managers make accounting choices for any of the reasons discussed here, when the motivation is an objective other than to provide useful information, earnings quality suffers. As mentioned frequently throughout this text, earnings quality refers to the ability of reported earnings (income) to predict a company's future earnings.
A notable example of alleged “cooking the books” involved General Electric. The company was often suspected of using “cookie jar accounting,” the practice of using unrealistic estimates and strategic choices of accounting methods to smooth out its earnings. In 2009 GE appeared to get its hand caught in the cookie jar for going beyond acceptable limits. GE paid a $50 million civil penalty to settle charges by the Securities and Exchange Commission accusing the company of violating U.S. securities laws four times between 2002 and 2003 to help it maintain a succession of earnings reports that beat Wall Street expectations each quarter from 1995 through 2004.
Let's turn our attention now to situations involving changes in methods and how we account for those changes.●
The Retrospective Approach: Most Changes in Accounting Principle
We report most voluntary changes in accounting principles retrospectively.6 This means reporting all previous period's financial statements as if the new method had been used in all prior periods. An example is provided in Illustration 20-1.
Change in Accounting Principle
LIFO usually produces higher cost of goods sold than does FIFO because more recently purchased goods (usually higher priced) are assumed sold first.
Air Parts Corporation used the LIFO inventory costing method. At the beginning of 2011, Air Parts decided to change to the FIFO method. Income components for 2011 and prior years were as follows ($ in millions):
Air Parts has paid dividends of $40 million each year beginning in 2004. Its income tax rate is 40%. Retained earnings on January 1, 2009, was $700 million; inventory was $500 million.
1. REVISE COMPARATIVE FINANCIAL STATEMENTS. For each year reported in the comparative statements, Air Parts makes those statements appear as if the newly adopted accounting method (FIFO) had been applied all along. As you learned in Chapter 1, consistency is one of the important qualitative characteristics of accounting information.
When accounting changes occur, the usefulness of the comparative financial statements is enhanced with retrospective application of those changes.
Earnings per share each year, of course, also will be based on the revised net income numbers.
The company recasts the comparative statements to appear as if the accounting method adopted in 2011 (FIFO) had been used in 2010 and 2009 as well.
Inventory. goods acquired, manufactured, or in the process of being manufactured for sale. In its comparative balance sheets, Air Parts will report 2011 inventory by its newly adopted method, FIFO, and also will revise the amounts it reported last year for its 2010 and 2009 inventory. Each year, inventory will be higher than it would have been by LIFO. Here's why:
Since the cost of goods available for sale each period is the sum of the cost of goods sold and the cost of goods unsold (inventory), a difference in cost of goods sold resulting from having used LIFO rather than FIFO means there also is an opposite difference in inventory. Because cost of goods sold by the FIFO method is less than by LIFO, inventory by FIFO is greater than by LIFO. The amounts of the differences and also the cumulative differences over the years are calculated in Illustration 20-1A.
FIFO usually produces lower cost of goods sold and thus higher inventory than does LIFO.
Effects of Switch to FIFO
By FIFO, cost of goods sold is lower.
The cumulative income effect increases each year by the annual after-tax difference in COGS.
Inventory, pretax income, income taxes, net income, and retained earnings all are higher.
Comparative balance sheets, then, will report 2009 inventory $345 million higher than it was reported in last year's statements. Likewise, 2010 inventory will be increased by $400 million. Inventory for 2011, being reported for the first time without restatement, is $460 million higher than it would have been if the switch from LIFO had not occurred.
Retained earnings. amounts earned by the corporation on behalf of its shareholders and not (yet) distributed to them as dividends. Similarly, Air Parts will report retained earnings by FIFO each year as well. Retained earnings is different because the two inventory methods affect income differently. Because cost of goods sold by FIFO is less than by LIFO, income and therefore retained earnings by FIFO are greater than by LIFO.
When costs are rising, FIFO produces lower cost of goods sold than does LIFO and thus higher net income and retained earnings.
Comparative balance sheets, then, will report retained earnings for 2011, 2010, and 2009 at amounts $276, $240, and $207 million higher than would have been reported if the switch from LIFO had not occurred. These are the cumulative net income differences shown in Illustration 20-1A.
Retained earnings is revised each year to reflect FIFO.
Statements of shareholders' equity.
Recall that a statement of shareholders' equity reports changes that occur in each shareholders' equity account starting with the beginning balances in the earliest year reported.
So, if retained earnings is one of the accounts whose balance requires adjustment due to a change in accounting principle (and it usually is), we must adjust the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders' equity. The amount of the revision is the cumulative effect of the change on years prior to that date. Air Parts will revise its 2009 beginning retained earnings since that's the earliest year in its comparative statements. That balance had been reported in prior statements as $700 million. If FIFO had been used for inventory rather than LIFO, that amount would have been higher by $180 million as calculated in Illustration 20-1A. The disclosure note pertaining to the inventory change should point out the amount of the adjustment. The January 1, 2009, retained earnings balance reported in the comparative statements of shareholders' equity below has been adjusted from $700 million to $880 million.
Because it’s the earliest year reported, 2009’s beginning retained earnings is increased by the $180 million cumulative income effect of the difference in inventory methods that occurred before 2009.
Comparative Statements of Shareholders' Equity
A footnote should indicate that the beginning retained earnings balance has been increased by $180 million from $700 million to $880 million.
2. ADJUST ACCOUNTS FOR THE CHANGE. Besides reporting revised amounts in the comparative financial statements, Air Parts must also adjust the book balances of affected accounts. It does so by creating a journal entry to change those balances from their current amounts (from using LIFO) to what those balances would have been using the newly adopted method (FIFO). As discussed in the previous section, differences in cost of goods sold and income are reflected in retained earnings, as are the income tax effects of changes in income. So, the journal entry updates inventory, retained earnings, and the income tax liability for revisions resulting from differences in the LIFO and FIFO methods prior to the switch, pre-2011. Repeating a portion of the calculation we made in Illustration 20-1A, we determine the difference in cost of goods sold and therefore in inventory.
The $400 million cumulative difference in cost of goods sold also is the difference between the balance in inventory and what that balance would have been if the FIFO method, rather than LIFO, had been used before 2011. Inventory must be increased by that amount. Retained earnings must be increased also, but by only 60% of that amount because income taxes would have been higher by 40% of the change in pretax income.
Cost of goods sold would have been $400 million less if FIFO rather than LIFO had been used in years before the change.
Inventory would have been $400 million more and cumulative prior earnings $240 more if FIFO rather than LIFO had been used.
Notice that the income tax effect is reflected in the income tax payable account. The reason is that an accounting method used for tax purposes cannot be changed retrospectively for prior years. The Internal Revenue Code requires that taxes saved previously ($160 million in this case) from having used another inventory method must now be repaid (over no longer than six years). As a result, this liability has both current (portion payable within one year) and noncurrent (payable after one year), but is not a deferred tax liability.
What if the tax law did not require a recapture of the tax difference? Then there would be a credit to a deferred tax liability. That's because retrospectively increasing accounting income, but not taxable income, creates a temporary difference between the two that will reverse over time as the unsold inventory becomes cost of goods sold. Recall from Chapter 16 that in the meantime, there is a temporary difference, reflected in the deferred tax liability.
If we were switching from FIFO to, say, the average method, we would record a deferred tax asset instead. For financial reporting purposes, but not for tax, we would be retrospectively decreasing accounting income, but not taxable income. This creates a temporary difference between the two that will reverse over time as the unsold inventory becomes cost of goods sold. When that happens, taxable income will be less than accounting income. When taxable income will be less than accounting income as a temporary difference reverses, we have a “future deductible amount” and record a deferred tax asset.
3. DISCLOSURE NOTES. To achieve consistency and comparability, accounting choices once made should be consistently followed from year to year. Any change, then, requires that the new method be justified as clearly more appropriate. In the first set of financial statements after the change, a disclosure note is needed to provide that justification. The note also should point out that comparative information has been revised, or that retrospective revision has not been made because it is impracticable, and report any per share amounts affected for the current period and all prior periods presented. Disclosure of a recent change by IDEX Corporation in its June 30, 2009 quarterly report provides us the example shown in Graphic 20-3.
Footnote disclosure explains why the change was needed as well as its effects on items not reported on the face of the primary statements.
Disclosure of a Change in Inventory Method—IDEX Corporation
Real World Financials
Inventories are stated at the lower of cost or market. Cost, which includes material, labor, and factory overhead, is determined on a FIFO basis. Prior to 2009, we valued certain inventories under the LIFO cost method. As of January 1, 2009, we changed our method of accounting for these inventories from the LIFO method to the FIFO method. As of December 31, 2008, the inventories for which the LIFO method of accounting was applied represented approximately 85% of total net inventories. We believe that this change is to a preferable method which better reflects the current cost of inventory on our consolidated balance sheets. Additionally, this change conforms all of our worldwide inventories to a consistent inventory costing method and provides better comparability to our peers. We applied this change in accounting principle retrospectively to all prior periods presented herein in accordance with SFAS No. 154, “Accounting Changes and Error Corrections.” [FASB ASC 250–10–45] As a result of this accounting change, our retained earnings as of January 1, 2009, decreased to $822.3 million using the FIFO method from $845.4 million as originally reported using the LIFO method. The following tables summarize the effect of the accounting change on our consolidated financial statements.
The Prospective Approach
Although we usually report voluntary changes in accounting principles retrospectively, it's not always practicable or appropriate to do so.
THE PROSPECTIVE APPROACH: WHEN RETROSPECTIVE APPLICATION IS IMPRACTICABLE. For some changes in principle, insufficient information is available for retrospective application to be practicable. Revising balances in prior years means knowing what those balances should be. But suppose we're switching from the FIFO method of inventory costing to the LIFO method. Recall from your study of inventory costing methods that LIFO inventory consists of “layers” added in prior years at costs existing in those years. If another method has been used, though, the company likely hasn't kept track of those costs. So, accounting records of prior years usually are inadequate to report the change retrospectively. In that case, a company changing to LIFO usually reports the change prospectively, and the beginning inventory in the year the LIFO method is adopted becomes the base year inventory for all future LIFO calculations. Footnote disclosure should indicate reasons why retrospective application was impracticable. Prospective changes usually are accounted for as of the beginning of the year of change.
When Books A Million, Inc., adopted the LIFO cost flow assumption for valuing its inventories, the change was reported in a disclosure note as shown in Graphic 20-4.
Sometimes a lack of information makes it impracticable to report a change retrospectively so the new method is simply applied prospectively.
When it is impracticable to determine some period-specific effects. A company may have some, but not all, the information it needs to account for a change retrospectively. For instance, let's say a company changes to the LIFO inventory method effective as of the beginning of 2011. It has information that would allow it to revise all assets and liabilities on the basis of the newly adopted method for 2010 in its comparative statements, but not for 2009. In that case, the company should report 2010 statement amounts (revised) and 2011 statement amounts (reported without restatement for the first time) based on LIFO, but not revise 2009 numbers. Then, account balances should be retrospectively adjusted at the beginning of 2010 since that's the earliest date it's practicable to do so.
If it’s impracticable to adjust each year reported, the change is applied retrospectively as of the earliest year practicable.
Disclosure of a Change to LIFO—Books A Million, Inc.
Real World Financials
Inventories (in part)
… the Company changed from the first-in, first-out (FIFO) method of accounting for inventories to the last-in, first-out (LIFO) method. Management believes this change was preferable in that it achieves a more appropriate matching of revenues and expenses. The impact of this accounting change was to increase “Costs of Products Sold” in the consolidated statements of operations by $0.7 million for the fiscal year. … The cumulative effect of a change in accounting principle from the FIFO method to LIFO method is not determinable. Accordingly, such change has been accounted for prospectively.
When it is impracticable to determine the cumulative effect of prior years. Another possibility is that the company doesn't have the information necessary to retrospectively adjust retained earnings, but does have information that would allow it to revise all assets and liabilities for one or more specific years. Let's say the records of inventory purchases and sales are not available for some previous years, which would have allowed it to determine the cumulative effect of applying this change to LIFO retrospectively. However, it does have all of the information necessary to apply the LIFO method on a prospective basis beginning in, say, 2009. In that case, the company should report numbers for years beginning in 2009 as if it had carried forward the 2008 ending balance in inventory (measured on the previous inventory costing basis) and then had begun applying LIFO as of January 1, 2009. Of course there would be no adjustment to retained earnings for the cumulative income effect of not using LIFO prior to that.
If full retrospective application isn’t possible, the new method is applied prospectively beginning in the earliest year practicable.
THE PROSPECTIVE APPROACH: WHEN MANDATED BY AUTHORITATIVE PRONOUNCEMENTS. Another exception to retrospective application of voluntary changes in accounting principle is when authoritative literature requires prospective application for specific changes in accounting methods. For instance, for a change from the equity method to another method of accounting for long-term investments, GAAP requires the prospective application of the new method.7 Recall from Chapter 12 that when an investor's level of influence changes, it may be necessary to change from the equity method to another method. This could happen, for instance, if a sale of shares causes the investor's ownership interest to fall from, say, 25% to 15%, resulting in the equity method no longer being appropriate. When this situation happens, no adjustment is made to the remaining carrying amount of the investment. Instead, the equity method is simply discontinued and the new method applied from then on. The balance in the investment account when the equity method is discontinued would serve as the new “cost” basis for writing the investment up or down to fair value on the next set of financial statements.
If an authoritative pronouncement specifically requires prospective accounting, that requirement is followed.
INTERNATIONAL FINANCIAL REPORTING STANDARDS
The changes to and from the LIFO method we've discussed would not occur if International standards were being applied. Why? Remember from Chapter 7 that LIFO is not a permissible method for accounting for inventory under IFRS.
THE PROSPECTIVE APPROACH: CHANGING DEPRECIATION, AMORTIZATION, AND DEPLETION METHODS. A change in depreciation methods is considered to be a change in accounting estimate that is achieved by a change in accounting principle. As a result, we account for such a change prospectively—precisely the way we account for changes in estimates. We discuss that approach in the next section.
2R. L. Watts and J. L. Zimmerman, “Towards a Positive Theory of the Determination of Accounting Standards,” The Accounting Review, January 1978, and “Positive Accounting Theory: A Ten Year Perspective,” The Accounting Review, January 1990.
3For example, see P. M. Healy, “The Effect of Bonus Schemes on Accounting Decisions,” Journal of Accounting and Economics, April 1985, and D. Dhaliwal, G. Salamon, and E. Smith, “The Effect of Owner versus Management Control on the Choice of Accounting Methods,” Journal of Accounting and Economics, July 1992.
4R. M. Bowen, E. W. Noreen, and J. M. Lacy, “Determinants of the Corporate Decision to Capitalize Interest,” Journal of Accounting and Economics, August 1981.
5This political cost motive is suggested by R. L. Watts and J. L. Zimmerman, “Positive Accounting Theory: A Ten Year Perspective,” The Accounting Review, January 1990, and M. Zmijewski and R. Hagerman, “An Income Strategy Approach to the Positive Theory of Accounting Standard Setting/Choice,” Journal of Accounting and Economics, August 1981.
6FASB ASC 250–10–45: Accounting Changes and Error Corrections–Overall–Other Presentation Matters (previously “Accounting Changes and Error Corrections—A Replacement of APB Opinion No. 20 and FASB Statement No. 3,” Statement of Financial Accounting Standards No. 154, (Norwalk, Conn: FASB, 2005)).
7FASB ACS 323–10–35–35: Investments–Equity Method and Joint Ventures–Overall–Subsequent Measurement–Decrease in Level of Ownership or Degree of Influence (previously “The Equity Method of Accounting for Investments in Common Stock,” Accounting Principles Board Opinion No. 18 (New York: AICPA, 1971)).